On May 26, 2009, LMSB issued Tier I Issue – Section 965 Foreign Earnings Repatriation Directive #3 setting forth procedures for examiners to follow when closing cases that include Section 482 adjustments that may affect the amount of the Section 965 dividends received deduction (“DRD”). Directive #3 states in part:

If a Section 482 adjustment proposed for tax years ending between the initial measurement date and last measurement date is unagreed at the examination level, a protective adjustment should be made to the Section 965 DRD as if the taxpayer had elected to apply Rev. Proc. 99-32. Doing so preserves the Service’s ability to make necessary adjustments to the DRD if the taxpayer later elects to apply Rev. Proc. 99-32 in Appeals, during Competent Authority consideration, or at some other later date as allowed by law. [Emphasis added.]

This Alert provides additional guidance regarding the “protective adjustment” that should be made to the Section 965 DRD in those cases in which the Section 482 adjustment proposed for tax years ending between the initial measurement date and last measurement date is unagreed at the examination level[1]. This guidance pertains to cases that are forwarded to Appeals or in which a 30-day letter is issued to the taxpayer affording Appeals rights. This guidance does not cover the specific language that should be included within statutory notices of deficiency (“SNOD”) regarding the Section 965 protective adjustment. The Section 965 Technical Advisors, Linda Azen or Larry Smeltzer should be contacted with respect to the appropriate SNOD language.

With respect to cases sent to Appeals, if a Section 482 adjustment proposed for tax years ending between the initial measurement date and last measurement date is unagreed at the examination level, a protective adjustment should be made to the Section 965 DRD as if the taxpayer had elected to apply Rev. Proc. 99-32. This protective adjustment does not need to be made in the form of an actual numerical adjustment to the Section 965 DRD amount. Rather the examiner may simply include the following language in the 30-day letter and/or the transmittal letter sent to Appeals, and in the International Examiner’s Report and Forms 5701 (Notice of Proposed Adjustment) and 886-A (Explanation of Items):

If all or part of the adjustment [482 adjustment amount] is sustained and the taxpayer elects to obtain the benefits of Rev. Proc. 99-32 with respect to the sustained adjustment, then it is further determined that the accounts receivable established under Rev. Proc. 99-32 shall be treated as Sec. 965(b)(3) related party indebtedness arising as of the last day of the respective taxable year for which the sustained adjustment is made. Accordingly, the taxpayer’s Sec. 965 qualifying dividends for the taxable year [taxable year of reported DRD] will be reduced by the amount of the increase in related party indebtedness treated as arising between [initial measurement date], and [the last measurement date], pursuant to the establishment of accounts receivable under Rev. Proc. 99-32.

Questions regarding this directive or the development of any issues involving Section 965 foreign earnings repatriation should be directed to Technical Advisors, Linda Azen or Larry Smeltzer at (717)-777-9609 or (717)- 757-2320, respectively or Section 965 Industry Counsel, Glenn McLoughlin or Christine Irwin at ((405)- 297-4803 or (720)- 956-4012, respectively.

[1] Section 965(b)(3) provides that the “initial measurement date” means the close of October 3, 2004 (but see Notice 2005-38, section 7, which allows certain alternative dates to be used), and that the “last measurement date” means the close of the last day of the taxable year for which the taxpayer elects to apply Section 965. If the related party indebtedness (“RPI”) as defined under Section 965(b)(3) on the last measurement date exceeds the RPI on the initial measurement date (treating for this purpose all of the controlled foreign corporations (CFCs) with respect to which the taxpayer is a United States shareholder within the meaning of Section 951(b) as one CFC), the amount of cash dividends that otherwise would qualify for the DRD is reduced dollar-for-dollar by the amount of the increase in RPI.